Aug 18, 2014

Two Types of Trust in Finance

By Mitchell Petersen

Determining how projects are valued is a primary interest of corporate finance. Part of valuation is technical: you forecast the revenue, forecast the cost, forecast the inventory, shove it in a spreadsheet, and out comes a pristine answer, perfectly accurate to four decimal places.

Except that number isn’t as accurate as you think. The project has to be feasible, it has to be profitable enough, and it has to be a project that no one else has done yet. But why has no one else done it? The answer is either because it’s infeasible, it’s not profitable enough, or because no one else has thought of it. So the key is to be the first person to think of a feasible, profitable project.

That is why innovation and growth are so challenging. A lot of the projects you don’t see happen are the ones that are infeasible: we don’t have the technology, the inputs are too costly, or the customer doesn’t like it. But if you take the defeatist attitude that, “if it was profitable, it would already be done,” we wouldn’t have any growth.

So innovating amounts to successfully navigating the tension between wondering what you’re missing that makes the project infeasible and wondering what you see that nobody else does. The trick is to be able to find that sweet spot, right between these two ways of thinking. Acting on this information requires trust (both of yourself, and of others) because, by definition, opportunities cannot be perfectly verifiable.

Trusting yourself is a good first step. People without a background in finance often feel like they can’t conquer it. That’s because finance is a technical field, with an enormously complicated vocabulary. Twenty percent of the reason the language is so complex is because the concepts are complex. My job, as a professor, is to demystify the concepts and therefore the language. Eighty percent of the reason the language is complex is because it serves as an entry barrier: complexity keeps people out. Here, my job is to bring them into the conversation. If I can take these incredibly talented individuals, give them a toolbox, and get them to trust that they can use it, then we win.

But being trusted by others is also key. Roughly speaking, economics is the study of trade. Say I grow corn and you raise chickens. If I give you two bushels of corn, you’ll give me six chickens. Finance is a subset of economics. It is the study of trading money now for an uncertain amount of money later. But how do you trust that people will give you that money back?

Thus, finance—a very modern, analytical field of study—actually depends on something that’s been around in human society for millennia: social trust. If you go back thousands of years, most finance was done locally. We would only trade with the people we knew and trusted: family, friends, and neighbors we were likely to see again.

In fact, the first banks weren’t places where you would put your money to get interest; they were places where you would put your gold to store it. If you kept the gold at home, after all, someone might steal it. So you would give it to someone who would guard it for you—and instead of paying you two percent interest, they would charge you two percent interest.

Gold is high value, but low weight, so what’s to keep that person from disappearing one night with your life savings? Notably, the people who started banks tended to be owners of vast tracts of land, because if they ran away, they left assets behind. The original bankers, the original financiers, were people for whom trust was enforced via family reputation or status in the community—but also, literally, people who couldn’t run away in the middle of the night.

In an important sense, not much has changed. Nowadays when you ask people to give you money to fund a project, in the hopes of maybe giving them more money later, you’re asking them to make a leap of faith, to believe in you.

Editor's Note: Mitchell Petersen is Glen Vasel Professor of Finance and Director of the Heizer Center for Private Equity and Venture Capital, Kellogg School of Management, Northwestern University. Photo credit belongs to Katie Brady published under a Creative Commons license.